Like many countries, the Greek government relies on borrowed money to balance its books. The recession has made this harder to achieve, because tax revenues are falling just as welfare payments start to rise. It doesn't help that, in Greece, tax evasion is commonplace and pension rights are unusually generous – but, to be fair, using public spending to even out the bumps of the global downturn is what most large developed economies are trying to do right now.

Unfortunately, investors have lost confidence in the Greek government's ability to walk this tightrope – so they have been demanding ever higher rates of interest to compensate for the risk that they might not get their money back. The higher its borrowing costs, the harder it is for the Greek economy to grow itself out of trouble.

Events began to spiral out of control when credit rating agencies downgraded Greek government debt to "junk" status, pushing the cost of borrowing so high that the country effectively had its international overdraft facility cancelled overnight. Fearing bankruptcy, Greece had to turn instead to the European Union and the International Monetary Fund (IMF) – the world's lender of last resort – for up to 120bn euros of replacement lending.

But political opposition in Germany and IMF orthodoxy in Washington demands that the rescue package comes with strings attached: a tough series of public sector cuts designed to reassure international investors that the government can become creditworthy again.

The snag is, this traditional market response is complicated by Greece's membership of the single-currency euro club. This means it cannot stimulate growth by devaluing its currency, and nor can it cut interest rates any further, which would help, because these are decided by the European Central Bank in Frankfurt. Instead, the public sector cuts are almost certain to deepen the Greek recession, reducing tax revenues and making it even harder to service the debts in future.

What many investors fear is that the only way out of this vicious circle is for Greece to walk away from its existing debts and try to go it alone – potentially triggering a wave of similar defaults in other indebted European countries, and jeopardising the euro itself. In the meantime, what many Greeks fear is that the IMF option is just going to prolong the agony – and drive the country to the brink of political as well as economic collapse.